Today’s Trading Lesson From TradingMarkets

Sometimes failed patterns can be the strongest patterns. Here we’ll look at
three simple patterns — expansion bars, gaps and flags– and show examples of
how their failures can lead to sizable moves opposite
the direction anticipated by their patterns.

Expansion Bar Failures

Expansion bars, or bars with larger-than-normal ranges, generally provide a
strong indication that a market will continue moving in the direction of the
expansion. They are a good clue that a market will follow through in the
direction of the expansion’s momentum. To demonstrate examples of successful
expansion bars, take a look at the following 10-minute chart of the yen. I’m
using intraday bars to highlight that patterns work in multiple time frames and
are relevant for futures as well as for stocks. On July 27, 2001, two expansion
bars — two of the widest-ranging 10-minute bars of the session — ratcheted the
September yen (JYU1)
to higher levels.

But when this bar pattern does not work out and follow through in the
direction of the momentum pulse, a sizeable move in the
opposite direction may be in store. As a
guideline to determining the “failure”
of an expansion bar, if a market closes below the low of an upside
expansion, or above the high of a down-expansion bar within the next few bars,
than that is considered a failure.

Again in an intraday timeframe, let’s take another look at the yen and notice
how two successive downside expansion bars failed to follow through. In both
instances in the chart below, the yen expanded (two of the biggest downside bars
of the session) to new intraday lows, but quickly (the next bar!) turned
around and traded back inside the previous range.

Notice that such expansions left a “spike” or a “tail,” bars themselves that
are often associated with a reversal. In essence, spikes and tails are often
just failed expansion bars. In this case, the failure to expand to new lows
resulted in an explosive intraday move in the yen
opposite the intended direction of the pattern on the following day.

Gap Failures

Gaps come in different flavors and their reliability as pattern indicators
depends on where they occur in the trend. Breakaway, continuation (or measuring)
and exhaustion gaps are the three broad categories of gaps that have directional
meaning to technicians. Exhaustion gaps happen at the end of a long price run-up
and signal the end of the trend, awaited reversal patterns themselves that will
not be considered here, although some of their underlying principals are the
same. Here, our focus is on the failure of continuation patterns. Breakaway and
measuring gaps, since they have the potential, still, to at least double from
where they occur, are continuation patterns.

As an example of successful continuation gaps, have a glance at the chart in
feeder cattle. After both the breakaway and the continuation gaps, feeders moved
decisively in the direction of the gaps.

But in the chart below, you will see an instance of a failed continuation (or
measuring) gap in sugar. Notice that the gap and expansion initially failed to
follow through. Sugar closed below the low of the gap on the day
following the gap, an unhealthy warning sign. And on the fourth day after the
gap, sugar closed below the close of the day prior to the gap:
confirmation of a failed continuation gap pattern.

But a wrench was thrown into this market. On the day following the
confirmation of the failed measuring gap, sugar exploded out of a Pullback From
Highs setup — the expansion bar on the chart — essentially
reversing the confirmed gap failure.
But in an added twist, sugar again reversed on the next trading day in an
even bigger downside bar that closed both below the gap, the failed gap
confirmation, and below the low of the upside expansion. In this case, you had
the confirmation of two failed patterns: a failure to follow through on the
continuation gap and a failure to follow through on the above described
expansion pattern.

Confirmation of the double failure laid to rest any hope of additional
upside. And although sugar did move back to test the initial confirmation of the
gap failure — the close that closed the gap — it did not rise above that level
and proceeded to lose 13% in three weeks.

Flag Failures

Flag formations are widely known, consolidation pullback patterns that occur
after a rapid, sharp price move. The flagpole — the sharp price increase or
decrease — is part of the key to this pattern because it identifies the
presence of momentum and the enhanced likelihood of a continuation move in the
direction of the pole. After a sharp move, markets, obeying the laws of physics,
often consolidate to gather “steam” prior to proceeding in the directing of
their momentum impulse, forming the flag.

A failed flag pattern occurs when a market shows successive closes beyond
the flag formation but in the opposite
direction of the flagpole’s momentum. A failure to move in the direction of the
flag pattern can be explosive, as the 15-handle move from the flag’s failure
point in the S&Ps (SPU1)
on August 10, 2001, demonstrates in the following chart.

You may want to bear in mind three additional factors that make flag patterns
more prone to failure. One, the flagpole is too short, showing insufficient
momentum. Two, the flag itself is too long, generally greater than 15 periods,
essentially “timing” the flag out. Three, the flag occurs in a severely
overbought or oversold market where the momentum has run out.

In thinking about the ever-present likelihood of failed patterns, remember this: “Fast Moves Come From False Moves.”